You would like to hold a protective put position on the stock of Avalon Corporation to lock in a guaranteed minimum value of $50 at year-end. Avalon currently sells for $50. Over the next year, the stock price will increase by 10% or decrease by 10%. The T-bill rate is 5%. Unfortunately, no put options are traded on Avalon Co.
What would have been the cost of a protective put portfolio?
A) $48.81
B) $51.19
C) $52.38
D) $53.38

Question

Quizplus · Accepted Answer

The hedge ratio is −0.5. A portfolio comprising one share and two puts would provide a guaranteed payoff of 55, with present value of 55/1.05 = 52.38. Therefore,
S + 2P = 52.38
50 + 2P = 52.38
P = 1.19
The protective put strategy = 1 share + 1 put = 50 + 1.19 = 51.19

You Would Like to Hold a Protective Put Position on the Stock